RBI’s Rajan Sees Risk of Financial Markets Crash

Reserve Bank of India Governor Raghuram Rajan warned Wednesday that the global economy bears an increasing resemblance to its condition in the 1930s, with advanced economies trying to pull out of the Great Recession at each other’s expense.

The difference: competitive monetary policy easing has now taken the place of competitive currency devaluations as the favored tool for playing a zero-sum game that is bound to end in disaster. Now, as then, “demand shifting” has taken the place of “demand creation,” the Indian policymaker said.

As was the case in the 1930s, the lack of coordination between policymakers is producing spillovers that may be difficult to control, and the world’s financial system may soon face fresh turbulence at a time when central banks have yet to repair the damage that the 2008 financial crisis caused to developed economies.

“We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost,” said Mr. Rajan in an interview with the Central Banking Journal.

A sudden shift in asset prices could happen in a variety of ways, Mr. Rajan said. The most obvious route would be as a result of investors chasing higher yields at a time when they believe central bank policies will protect them against a fall in prices.

“They put the trades on even though they know what will happen as everyone attempt to exit positions at the same time – there will be major market volatility,” said Mr. Rajan.

A clear symptom of the major imbalances crippling the world’s financial market is the over valuation of the euro, Mr. Rajan said.

The euro-zone economy faces problems similar to those faced by developing economies, with the European Central Bank’s “very, very accommodative stance” having a reduced impact due to the ultra-loose monetary policies being pursued by other central banks, including the Federal Reserve, the Bank of Japan and the Bank of England.

“The exchange rate is too strong given the euro area’s economic standing,” said Mr. Rajan, who took over the RBI in September.

Mr. Rajan said economists still disregard the central role of financial systems in the economy and believe they can predict upcoming disruptions.

“They still do not pay enough attention–en passant–to the financial sector,” Mr. Rajan said. “Financial sector crises are not as predictable. The risks build up until, wham, it hits you.”

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